Monday, 17 October 2016

India lacks the institutional mechanisms to deal with the death of firms and the failure of banks.

Bank credit to the industrial sector has started shrinking. Its
decline has been a serious cause for concern as credit growth is
essential to revive investment. However, the logjam is not a
short-term problem. The problem's origins lie in the incomplete
reforms of the last 25 years. We hoped for the best and did not
prepare for the worst. We failed to prepare for the inevitable
business cycle downturns that a market economy witnesses.

The inability of banks to lend to industry appears to have pushed
them to lend more to retail consumers. This will, to some extent, help
industry which has been operating at below capacity. The phenomenon
may be helped further by a rise in the salaries of civil servants, a
good monsoon and a pick up in public investment.

In a traditional market economy, one might have thought that a pick
up in capacity utilisation will mark the beginning of a
self-correcting process of bringing about an upswing in the investment
cycle. At this point, when investment in the Indian economy has been
declining, this would have helped answer the most difficult policy
puzzle faced by the Indian economy. But this may not happen soon
enough.

If the decline in bank credit had been only due to a lack of demand
for credit, then an increase in capacity utilisation would have
eventually pushed industry to further increase capacity and led to an
upturn in investment. But if the decline in credit growth is due to
high NPAs (non-performing assets) this may not happen. The magnitude
of stressed and restructured loans suggest that the latter is a
serious issue today.

If the reforms of 1991-1992 had clearly envisaged a move to a
market economy that inevitably has booms and busts, the government
should have, over the years, systematically put in place institutional
mechanisms for dealing with the death of firms, exits, bankruptcy and
failure of banks. At the same time, courts and contract enforcement
would have been made stronger. Instead, a naive version of a market
economy led to an institutional framework suitable for capitalism that
only witnesses booms.

Now that we have been stuck in a logjam for a few years we are
setting up an institutional mechanism to deal with bankruptcy and bank
failures. However, it will be a few years before we can build these
properly. Unfortunately, this means that the present situation will
not be resolved quickly.

A critical reform that should have followed the liberalisation of
industry should have been the development of a competitive private
banking sector. Our phase of planned industrial growth was over. Why
should the government have had a role in deciding which sector and
which borrower gets how much credit? Surely, if the government had to
genuinely allow industry to grow, it should not have been deciding who
gets the money to grow and who does not. But this was not the case. On
the one hand, the government continued to own banks; on the other it
continued giving directions to all banks, public and private, about
which sectors to lend and which were priority sectors.

Instead of moving to a largely private banking system, bank
licensing policy seems to have been dominated by a reluctance to allow
the share of private banking to increase beyond about a quarter of the
banking system. There was an inconsistency between the vision of
market-led industrial growth and government controlled resource
allocation.

Similarly, banking regulation needed to move away from central
planning mechanisms to one more appropriate for a market economy. It
should have undergone a philosophical change, moving away from
directing banks to invest in certain sectors to regulating and
monitoring the risks banks take in the business of banking. Reducing
this risk would have prepared the banking system better for the
bust. Instead, banks piled on a lot of risk in the boom years. Many of
those projects went bad in recent years. The banking regulator has
tried to come up with an alphabet soup of schemes like the CDR, SDR
and S4A. None of them has been able to solve the problems created by
inappropriate regulation in the first place.

An institutional change that should have followed the 1991 reforms
should have been setting up of a resolution corporation for banks. In
a market economy with booms and busts, banks should be allowed to be
set up and to fail. Today, we cannot shut down banks because there is
no proper system to shut them down. Weak loss-making banks continue to
need more capital. We forcibly merge them with healthier banks, making
them weak as well.

What is the way forward? In a privately owned banking system, banks
do the business of banking to make profits; they retain earnings and
they expand their equity capital and grow their balance sheets. If
they make losses and are unable to generate adequate profits and
retain capital, they are shut down or taken over by banks who have the
capital. In a government owned banking system banks cannot be shut
down. The only way out seems to be "recapitalisation", or putting tax
payer money into making up for the losses or loans not returned. The
situation is fraught with problems. Banks are not willing to either
recognise bad loans or sell off weak assets at losses. The regulator
is willing to give leeway knowing that government has limited money to
recapitalise loss making public sector banks. If banks are forced to
recognise losses and government cannot put money in, credit would only
decline further.

As long as the economy was small and business cycles were mild, we
somehow managed. However, after 2000 we saw a doubling of GDP, very
high growth, and then a sharp downswing of the business cycle after
2008. The antiquated pre-market institutional framework is not able to
provide the mechanisms the economy needs to get out of the
logjam. Policymakers have been looking for short-term answers.

This is the danger of looking for fixes when something is
broken. The approach of "don't fix it because it ain't broke" towards
India’s banking sector must be fundamentally re-examined.